How To Change A Pension Plan

Transcription

1 The Shift from Defined Benefit to Defined Contribution Pension Plans - Implications for Asset Allocation and Risk Management John Broadbent Domestic Markets Department Reserve Bank of Australia Sydney, NSW 2000 Michael Palumbo Division of Research and Statistics Federal Reserve Board 20 th and C Streets, NW Washington DC and Elizabeth Woodman Financial Markets Department Bank of Canada 234 Wellington, Ottawa Ontario K1A 0G9 December 2006 Prepared for a Working Group on Institutional Inve stors, Global Savings and Asset Allocation established by the Committee on the Global Financial System The analysis and conclusions set forth in this paper are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors or any other officials in the Federal Reserve System or at the Federal Reserve Bank of Australia or at the Bank of Canada.

2 Contents Executive Summary...i I. Introduction...1 II. Main Features of Defined Benefit and Defined Contribution Pension Plans and Distribution of Risks...3 A. Defined Benefit Pension Plans...3 B. Defined Contribution Pension Plans...7 C. Hybrid Pension Plans III. Extent of the Shift Away From Traditional DB Pension Plans A. Within the OECD B. Trends in Australia, Canada, the United Kingdom and the United States IV. Factors Contributing to the Shift to DC Plans in Private -Sector Pensions A. Regulatory and tax changes B. Increasing Costs of DB Pension Plans C. Changes in the Industry Composition of Employment D. Increase in Labour Mobility E. Introduction of 401 (k) plans F. Increasing Familiarity with the Stock Market G. Actual or Proposed Changes to Pension Accounting V. Implications of the Shift from DB to DC Pla ns on Asset Allocation A. Aggregate Asset Allocation in DB and DC Plans in the United States B. Aggregate Asset Allocation in DB and DC Pension Plans in Canada C. Aggregate Asset Allocation in DB and DC Pension Plans in Australia VI. Issues for Retirement Security Posed by DC Pension Plans A. Participation B. Contribution Rates C. Asset Allocation D. Withdrawal Patterns for DC Pension Accounts E. How Might DC outcomes be improved along some key dimensions? VI. Implications for Financial Markets A. Financial Market Efficiency B. Annuity Markets VIII. Conclusion Appendices References Box A Box B i

3 Executive Summary Traditional DB pension plans are gradually losing their dominance in the occupational pension systems of many countries; over the past few decades there has been a gradual shift towards DC pensions and, in some countries, DC plans now account for the majority of invested assets in private sector occupational pension plans. It is widely anticipated that recent and prospective regulatory and accounting reforms in the pension sectors of a number of countries will accelerate the ongoing shift from DB to defined contribution (DC) plans. In this note we have examined the shift from DB to DC plans with a view to assessing the implications for asset allocation and risk management. The transition from DB to DC plans in private sector pensions is shifting investment risk from the corporate sector to households. Households are therefore becoming increasingly exposed to financial markets, and retirement income may be subject to greater variability than before. This is not only the case in countries with a mature occupational pension system, but also interestingly in emerging markets, where pe nsion reforms (aimed at either setting up private occupational pension schemes or funding pay-as-you-go systems) are adopting a structure predominantly based on that of DC or hybrid schemes. A number of explanations have been offered for the shift from DB to DC pension plans. From a long-term perspective, factors such as increased workforce mobility associated with demographic and industrial change appear to have been important drivers of the shift away from DB pension plans, which has been particularly pronounced in the U.S. All else being equal, mobile workers have less of a preference for DB pensions because traditional benefit formulas are backloaded, favouring long-tenured employees, and because DB benefits are not portable from one employer to anot her. The recent acceleration of the trend towards DC plans appears to be linked to a confluence of factors (e.g., pension under-funding and its persistence due to a decline in long-term interest rates, the move to more marketbased accounting, increasing regulatory burden and uncertainty and recognition of the effects of increased longevity on plan costs) that has prompted plan sponsors to improve their management of the financial risks in DB plans. It is also linked to regulatory and accounting reform that is making the se risks more transparent. Since DC contributions can be fixed as a predictable share of payroll, migrating to a DC plan offers employers a means of reducing balance sheet and earnings volatility at least over the long term. The shift towards DC pensions does have some positive aspects, both for employees and for sponsor companies. Among them, it favours labour market mobility because it decreases so-called accrual risk, ie the fact that pension benefits in DB plans tend to be ii

4 backloaded, so that workers who change employers can lose a great portion of expected benefits if these are not transferable from one employer to another. However, such a shift also reallocates investment risk within the financial system from the corporate to the household sector, which may have implications for financial stability. Aggregate pension sector data available for Australia, Canada and the U.S., shows that asset allocations are quite similar for DB and DC plans, particularly in Australia where there are no differences of note. Both DB and DC plans hold most of their assets in equities and fixed income securities. One key difference noted in the asset allocations of U.S. and Canadian plans is that DC plans tend to hold a greater share of assets in mutual funds while DB plans tend to have higher weightings in directly held securities. In the US this applies to holdings of fixed income and equity. In Canada, the fixed income weightings for DB and DC plans are similar for both direct holdings and mutual funds. In both countries DC plans tend to hold a smaller share of equities in international stocks. DC plans also tend to have a larger share of assets in guaranteed insurance company contracts and other stable value instruments, although, aggregate sector weightings in money market and stable value funds are not that high. Despite the similarities in aggregate asset allocations, households do not necessarily manage risks in the most appropriate way. There is a large body of evidence to suggest that there is considerable inertia and myopia regarding retirement decisions, which may ultimately threaten the capacity of DC plans to provide retirement security. For example, research has shown that in some DC plans employees are generally investing too heavily in their own company s stock. Furthermore, employees tend to remain in a plan s default option even if it does not provide sufficient portfolio diversification. Finally, employees in DC plans may not have a sufficient number of investment options to create a portfolio suited for their investment objectives, risk tolerance and constraints. Retirement security for some households is threatened by a lack of participation, low contribution rates, suboptimal asset allocation, early withdrawals and a failure or inability to annuitise plan assets at retirement that may reflect well documented behavioural biases and a lack of basic financial literacy. Thus it is important for policymakers to address these issues. The experience of some institutional investors in emerging markets that created mandatory private pension funds some time ago may also be relevant for other countries moving from DB to DC schemes. iii

5 Introduction In a number of countries the pension sector is in the midst of regulatory and accounting reform 1. The reforms are largely a response to the deterioration in the funding of defined benefit (DB) pension plans from about and longstanding concerns regarding the effect of complex, opaque pension accounting methods on the valuation of the DB pension plan and the sponsoring firm. Recent and prospective reforms, in particular those aimed at introducing fair-value measurement and improved transparency in pension accounting, are expected to introduce greater volatility in the financial statements of sponsors. This is likely to provide more of an incentive for sponsors to adopt investment strategies such as asset-liability management, that are aimed at reducing wide fluctuations in the value of the DB plan surplus (the plan assets-the plan liabilities). Most expect that the reforms will also accelerate the ongoing shift from DB to defined contribution (DC) plans. This note addresses the latter, examining the shift from DB to DC plans with a view to assessing the implications for asset allocation and risk manage ment. Traditionally, funded occupational pension systems were designed around DB pensions; DC plans accounted for a small fraction of employer-sponsored pensions and were typically offered by smaller firms or as supplementary plans for high income earners. Over the past three decades there has been a gradual shift, predominantly in the private sector, towards employee-directed DC plans and hybrid arrangements that combine features of both DB and DC plans. Few new DB plans have been created and the majorit y of countries that have recently introduced funded occupational pensions have based them on DC or hybrid schemes. While in many countries DB plans remain the dominant form of pension, in some others DC plans are the most common type of pension and represent the majority of sector assets. Historically, the shift towards DC pension plans has largely been a response to changes in industrial structure and labour force composition that have given rise to an increasingly mobile workforce. DB plans, which are often not portable across employers, can penalize mobile workers since the expected pension benefit generally accrues only to employees who remain with the same employer throughout their career. DC plans avoid the accrual losses that can be associated with DB plans and provide mobile workers with much a more flexible means of managing the ir retirement savings. 1 The specific nature of the reforms that have been implemented or proposed in various countries and an assessment of their impact on asset allocation are discussed in two other reports of the Working Group: Broadbent, Palumbo, Santaella and Zanjani (2006) and Drudi, et.al (2006). 2 The deterioration in the funded status of DB plans occurred following the 3-year decline in global equity markets ( ) which acted somewhat as a catalyst for regulatory and accounting reform by drawing attention to existing weaknesses in traditional DB pension fund design, legislation, regulation and accounting. However, in some cases the reforms were underway earlier. For example, the move to FAS 17 in the United Kingdom was announced in 2000 even though it did not become effective until 2005.

6 Over the past several years the shift from DB to DC pensions has gained momentum, most notably in the United Kingdom (U.K.) where many large DB plans have been closed to new employees. 3 The recent acceleration appears to be mainly employer driven, and is largely a response to a confluence of factors (e.g., pension underfunding and its persistence due to a decline in long-term interest rates, the move to more market-based accounting, increasing regulatory burden and uncertainty and recognition of the effects of increased longevity on plan costs) that have reduced the incentives for employers to offer DB plans. Within the pension sector there has been much greater focus on managing pension fund assets relative to liabilities rather than market benchmarks. And, as is evident from the U.K. experience, this shift in focus is also linked to regulatory and accounting reform that is making the financial risks associated with DB plans more transparent. Since DC contributions can be fixed as a predictable share of payroll, migrating to a DC plan offers employers a means of reducing balance sheet and earnings volatility, at least over the long term. While the evolution towards DC pension plans can be beneficial for both employees and employers, it nevertheless reallocates risk within the financial system. In DB pension plans, responsibility for funding and investment management rests with the firm sponsoring the plan. In a DC plan these tasks and the associated risks are typically assumed by the employee. This shift of responsibilities and risks from the corporate sector to the household sector has potential implications for financial stability. In examining the shift from DB to DC pension plans and assessing the implications for asset allocation and risk management we first describe the main features of each type of plan and how risk is distributed between the employee and the employer. We then examine the extent of the shift towards DC plans and some of the factors driving it. To narrow the scope of our paper we focus on those countries with mature funded occupational pension systems originally designed around traditional DB plans and which currently account for the majority of global pension assets. 4 We focus in more detail on four countries: Australia, Canada, the United Kingdom (U.K.), and the United States (U.S.)., in which the shift to DC plans has progressed at different rates and has been driven by somewhat different factors. Where the data permits, we also examine aggregate asset allocations for DB and DC pension plans. We then turn to a review of the literature to examine how well households are managing the new set of risks that arise in DC pension plans. We conclude by raising some potential implications for financial market efficiency and stability and a few of the policy responses that have been proposed in the literature. 3 Even in the U.S. where the shift towards DC plans is part of a well established long term trend, recent closures are unusual in terms of their frequency and the large size of some employers. See EBRI (2006). 4 As noted earlier the shift towards DC plans is a global trend that is tied, in many respects, to recent pension reforms moving many countries to a model of funded pensions managed by the private sector

7 II. Main Features of DB and DC Pension Plans and Distribution of Risks In most countries with mature pension systems, employer pension plans are typically voluntary and workforce coverage may therefore be quite limited. These plans can be sponsored by an employer, an industry association or a labour union or professional organization. Employer pensions are generally governed by legislation and regulation intended to protect employee benefits 5 and they may offer tax advantages to the employer and/or employee to encourage sponsorship and participation respectively. Traditionally, most pension plans were structured to provide the employee with a life annuity at retirement. This is gradually changing, however. Some DC plans, for example, permit early withdrawals, loans, and/or lump sum distributions at retirement. It is also more common for DB plans to offer the retirement benefit as a lump sum rather than a life annuity. 6 Despite many common elements there is considerable cross-country variation in the design of retirement income systems. Differences in tax policy, social security programs, legislation, regulation and culture have given rise to a wide array of approaches to the pension system and to the design of DB and DC pension plans, both within and across countries. This in turn influences the distribution of risks assumed by employers and employees in each type of plan and may have implications for asset allocation. In this section we focus on the most common features of traditional DB and DC plans, with a particular emphasis on Australia, Canada, the U.K. and the U.S. We examine the key features of DB and DC pensions and consider how risks are distributed between employers and employees in each type of plan. It must be kept in mind that in some countries DB and DC plans may have unique features with somewhat different implications for the distribution of risks. As indicated earlier, our focus is private sector pensions; in most countries very little migration to DC plans has occurred in the public sector. A. Defined Benefit Pension Plans In a traditional defined benefit (DB) pension plan, workers accrue a promise of a regular monthly payment from the date of their retirement until their death, or, in some cases, until the death of their spouse. The promised life annuity (deferred) is commonly based on a formula linked to an employee s wages or salary and years of tenure at the sponsoring firm. In a typical DB plan the member earns a unit of pension, usually expressed as a percentage of nominal earnings, for each year of credited service/participation. The DB pension may be indexed to inflation but in a number of countries such as the U.S. and Canada this is uncommon in private sector pensions. Various measures are used for the earnings base; in Australia, the U.K., the U.S. and 5 In some countries such as Canada and the U.K. employer pension plans have historically been structured as trusts and hence are subject to trust law as well as pension legislation. 6 Indeed, although this report addresses the shift from DB to DC pension plans it is important to keep in mind, that the traditional distinction between DB and DC plans is becoming less meaningful

8 Canada, the most common is final salary generally the employee s average earnings over a specified period of time prior to retirement or earnings during a specified period of highest earnings. 7 In final salary plans the expected benefit is generally designed to replace a pre-determined percentage of final salary based on a specific employment tenure that is typically ranging from about 35 to 40 years. The replacement rate varies considerably across plans; the most generous DB plans are designed with a salary replacement ratio of between per cent of final salary. Employers are generally legally obligated to make the promised payments once they have accrued and have been vested; firms are under no obligation to pay benefits that might be expected but have yet to actually accrue. Under certain conditions employers may also terminate pension plans 8 in some countries (e.g., the U.S.) but prohibitive tax penalties typically persuade employers to transform the pension plan rather than terminating it. In other countries such as the U.K. and Canada, the DB plan text may prohibit the termination of the plan (Yermo, 2003). In practice, a full plan termination is often difficult to implement outside of corporate insolvency, particularly in highly unionized industries where a DB pension plan is usually a negotiated benefit. A full plan termination is therefore the least common of the three types of DB plan closures generally available to plan sponsors. These are 1) a hard freeze or termination (no additional benefits will accrue to any current plan members from either additional tenure or increases in compensation); 2) a soft freeze (generally limits increases for current plan members in accrued benefits due to increases in tenure but may allow the definition of compensation to increase); or 3) a partial freeze (plan is frozen for some but not all members). 9 The shift from DB to DC plans is, therefore, generally a gradual process incorporating a transition period in which the employer will offer two types of pension plans; a DB plan for existing employees and a DC plan for new hires. Employees in DB pension plans may face insolvency risk if the sponsoring firm declares bankruptcy at a time when the plan is less than fully funded. Solvency risk has been partially mitigated in some countries through the creation of a pension benefit guaranty agency such as the U.S. Pension Benefit Guaranty Corporation (PBGC) 10, or 7 Career average is generally used less extensively. In the Netherlands there has been a substantial shift from final salary to career average plans since the late 1990s and these plans currently apply to about 2/3 of total private sector pensions. Flat benefit plans, which specify a dollar amount of benefit for each year of service are also used by some employers. 8 In case of DB terminations, firms are obligated to pay accrued and vested benefits. 9 See Employee Benefits Research Institute (2006). The precise form of DB plan terminations could differ somewhat across countries. 10 In the U.S., firms that declare bankruptcy generally face much less stringent conditions for terminating their plans; in recent years this process has resulted in quite a number of large plan failures, particularly among firms in the steel and air transportation industries. When a bankrupt firm terminates its DB plan the PBGC assumes ownership of assets that had been set aside for funding pension benefits and takes over responsibility for making the promised payments to eligible retirees. As firms sometimes enter bankruptcy with under-funded pension plans the PBGC has seen its financial position deteriorate substantially over the past few years: the PBGC reported that for the end of its - 4 -

9 more recently, the U.K. Pension Protection Fund. In the event of bankruptcy these agencies will take over the responsibility for making some portion of the promised payments to retirees. In these types of arrangements the risks assumed by the guaranty fund may ultimately be passed on to taxpayers. The traditional DB pension framework imposes different types of risk on employers and employees. 11 In a DB pension fund the employer bears the risk of providing the employee with a pension benefit that, as noted earlier, is typically expressed as a specific replacement rate of pre-retirement gross earnings. The employer also bears market timing or temporal risk, in that DB plan assets may fall short of what is required to meet this obligation at the time of the employee s retirement. Through pooling of plan contributions across a number of employees, not all of whom will retire at the same time, the employer is able to manage market timing risk much better than an individual would be able to. In managing the overall financial risk associated with a DB pension plan the employer bears investment risk, the risk that actual returns on the assets set aside to fund accrued pension benefits may fall short of expectations; this could force employers to raise contributions if poor asset returns leave their pension plans sufficiently underfunded. Note that we use the term investment risk to encompass market, credit and other types of risk that might arise from investing plan assets. Employers can hedge market risk by investing in fixed income securities that match the duration or cash flows, of their accrued liabilities; and if they use highly-rated fixed income securities they can also limit credit risk. In practice, the majority of DB plans are heavily invested in publicly-traded equities (one-half to two-thirds of assets), accepting the exposure to market risk and the equity premium that serves as compensation to hold down expected pension contributions. 12 Employers also bear longevity risk because they are generally obligated to offer DB benefits as a deferred life annuity. Longevity risk is the risk that plan beneficiaries will live longer, on average, than originally expected, increasing the time period for paying the benefit. Employees, on the other hand, typically bear the brunt of inflation risk, because private DB plans generally do not index benefit payments for post-retirement increases in 2005 fiscal year the agency s liabilities exceeded its assets by about $23 billion, implying that about 30 percent of its current liabilities were unfunded. 11 The precise nature and magnitude of risk assumed by employers and employees is obviously a function of many factors that may be country specific. Yermo (2003) explains some of the additional types of risks encountered in the pension arrangements of various countries. 12 In addition, the traditional pension accounting standards for DB plans have encouraged sponsors to shift their investments toward corporate equity. FAS 87 and CICA 3461which apply to U.S. and Canadian firms respectively, allow sponsors to book expected portfolio earnings on pension assets as income and to amortize over several years any difference between expected and actual portfolio earnings. On average, this allows sponsors to bring an assumed equity premium into income while smoothing through, or even disguising, the associated portfolio risk. See Coronado and Sharpe (2003); Wiedman and Goldberg (2002)

10 the general price leve l. 13 While inflation risk can be substantial, perhaps the greatest source of risk in DB pensions is accrual or portability risk, which reflects the fact that benefits have traditionally been loaded toward long-tenured employment relationships. Since benefit payments (nominal) are often computed as the product of earnings and tenure (both of which tend to increase each year) the accrual pattern is nonlinear in dollar terms (and in present value), with much of the final benefit accruing in the final years before retirement. 14 Therefore, any changes affecting benefit payments that may occur toward the final years of work including changes to the benefit formula, plan terminations, or an employment separation can result in accrued benefits actually falling far short of a worker s expectations. And, pension shortfalls are a risk not only for long-tenured workers - accrual risks are also caused by fairly lengthy vesting periods 15 during which workers typically forfeit all of their DB benefits if their plan terminates or their relationship with the employer is severed. Unless the DB pension plan is portable, which is uncommon in private sector plans, the backloading of DB plan benefits is significant for employees who change employers during their working career. Blake (2003) estimated the accrual losses from DB pension schemes under various assumptions. He found that a typical U.K. worker who changed jobs at the average level of 6 times during their working career would suffer a loss of per cent of the full service benefit they would have received had they remained with the same employer throughout their career (see also Bodie, et.al, 1985). Accrual risk is less of an issue in multi-employer plans where the pension plan is generally portable across the employers belonging to the plan. In the Netherlands, for example, the majority of employer pension plans, apart from those of some of the largest firms, are industry-based. The distribution of risks for employers (ultimately the shareholders in private sector plans) and employees in DB pension plans are summarized in Table 1. Generally, the employer bears all the investment risks related to investing DB plan assets and funding shortfalls that arise for various reasons. DB pension plans are not without risk to employees, who typically bear inflation risk, vesting risk and the risk that the actual benefit received falls short of the expected salary replacement level at retirement. Outside of industry or multi-employer DB plans, accrual risk is high for employees who do not remain with the same employer throughout their working career. 13 Exceptions include the U.K. where Limited Price Indexation, introduced in 1997, required price indexation to a maximum of 5 per cent per year, although this was recently reduced to 2.5 per cent (Blake (2003), IMF (2004). In the Netherlands the extent of benefit indexation is related to the level of plan solvency so the inflation risk is linked to investment risk. 14 The accrual pattern for DB payments is typically linear in terms of replacement rates as these tend to rise by one percentage point per year. However, as workers gain more and more tenure with the sponsoring firm, the present value of DB pension benefits as a share of earnings tends to accelerate sharply in the years just before retirement, as the timing of the benefit payments approaches. 15 Traditionally, it was common to have vesting periods as high as 10 years. The trend in recent years has been towards shorter periods. In most Canadian provinces vesting is generally less than two years

11 Table 1: Risk Distribution in a DB Pension Plan Type of Risk Investment Inflation Longevity Market timing (temporal) Accrual (portability) Vesting Employer insolvency Salary replacement risk Who Assumes it? Employer Employee / Employer Employer Employer Employee Employee Employee / taxpayers Employer B. Defined Contribution Pension Plans In a defined contribution (DC) pension plan, workers accrue funds in individual accounts administered by the plan sponsor. The contributions of employees are typically deducted directly from their pay and frequently some portion of these contributions is matched by the employer. Since contributions to DC plans are generally a fixed percentage of earnings, DC assets build at a fairly steady rate over time (abstracting from the time-pattern of investment returns) avoiding the backloading of accrued benefits that is a hallmark of DB plans. 16 So in contrast to a DB plan, it is the contributions rather than the benefit that is fixed in a DC pension plan; the retirement income that will be provided is unknown in advance. The pension benefit accumulated during the employee s working career will depend on the contributions made while working and the investment returns earned on the plan balances. Similar to DB pension plans, there is considerable variation in DC plan design, legislation, regulation, and taxation; these differences influence the risks that plan members assume. Australian DC plans are somewhat unique. Participation is mandatory for all workers and their employers and minimum contributions are fixed by legislation. The most common type of DC plan in Canada and the U.K. is a traditional money purchase plan (MPP) organized as a trust 17. In the U.S. MPPs are less popular than the 401(k) plan which, according to Borzi (2005) accounts for 75 per cent of DC plan members. 18 Nonetheless these plans have many features in common. Within specified limits, plan contributions and investment income are not subject to personal income tax although withdrawals are taxed. 19 The plans are also governed by pension legislation and regulation. The main difference between a MPP and 401(k) plan is that the latter has features of both a traditional occupational pension plan and an individual retirement 16 There are some DC pension plans in which contribution rates increase with tenure. 17 A less common form of regulated DC plan is an employee profit sharing plan in which the benefit is linked to corporate profits rather than employee earnings. 18 MPPs are the traditional form of DC plan in the U.S. but have proven less popular than 401(k) plans due to a difference in tax treatment; contributions to MPPs are not tax deductible for the employee. 19 Australian superannuation funds are an exception. Since the 1980s, lump sum benefits, contributions and investment income are all taxed, albeit at a lower marginal rate. See Bateman and Piggott (2000)

12 savings plan. 20 Early withdrawals from a 401(k) are permitted but are taxable and subject to certain conditions and penalties (prior to age 59 ½). Also, lump sum distributions are permitted at retirement and when an employee changes jobs. In the U.K., Australia and Canada pension balances are locked-in until retirement age. Early withdrawals are not permitted and the purchase of an annuity is compulsory at age 69 in Canada and age 75 in the U.K.. In Canada, investment in a locked-in retirement savings account where annual withdrawal limits are pre-specified is also permitted. 21 Employees in Australian DC plans typically have the choice of purchasing an annuity or taking the entire balance as a lump sum withdrawal (as early as age 55); early withdrawals are only permitted in exceptional circumstances. Under pension legislation, DC plan assets belong to the worker, meaning that previous contributions are portable across employers or through employment spells. In a DC plan this generally means that the DC plan assets are controlled by the worker. A worker may be able to leave the plan assets under the administration of a previous employer, transfer the assets to a new employer s plan or transfer the assets to an individual retirement savings account. Similar to DB plans, DC plan benefits must be vested. If the plan is terminated prior to the vesting date, only employee contributions and interest are returned. By definition a DC pension plan is always fully funded and the employer typically has no financial obligation other than to make periodic payments into the plan, and, relative to a DB plan, the accounting treatment is quite simple ; payments to a DC plan are treated as any other corporate expe nse (Yermo, 2003). Thus, the constellation of risks facing workers covered by a DC plan is quite different than in a DB plan (See Table 2) : in a DC plan, workers bear investment and longevity risks, but do not face accrual risk. 22 Given that there is typically no mechanism for pooling investment risk in DC plans, the employee is also exposed to market timing risk at the point of retirement; this applies not only to the amount of cash balances available at retirement but also to the amount of annuity that can be purchased with this sum. A market downturn at the time of retirement could substantially erode the cash balance in a DC plan. For example, DC plan members who retired during the severe bear market in global equities from are likely to have retired with a much smaller plan balance than individuals who retired during the stock market boom of the late 1990s. Likewise the level of interest rates at the time of retirement influences the amount of the 20 According to Brown and Warshawsky (2000) 401(k) plans are not considered pension plans under U.S. law because they are not required to provide an annuity. 21 Recent changes to U.K. pension legislation permit a lump sum distribution of up to 25 per cent. Retirees previously had to purchase an annuity at age 65. The increase to age 75 was implemented to permit some flexibility in the timing of an annuity purchase, helping retirees to avoid periods of very low interest rates. 22 Individuals can avoid exposure to longevity risk by purchasing a fixed annuity with their DC plan assets upon retirement, but in many plans they must take this action explicitly (and bear the cost, as well)

13 retirement benefit if the employee is required (under pension legislation) or voluntarily decides to purchase an annuity. Table 2: Risk Distribution in a DC Pension Plan Type of Risk Investment Inflation Longevity Market timing (temporal) Accrual (portability) Vesting Employer insolvency Salary replacement risk Fiduciary / legal risk Who Assumes it? Employee Employee Employee Employee DC plans are portable Employee DC plans always fully funded Employee Employer In a DC plan the employee assumes salary replacement risk as well. Employees must not only calculate the amount of savings needed to retire but must also make a series of complex investment decisions to achieve their retirement goals. In many DC plans employees have considerable flexibility over participation, contribution amounts, portfolio allocations, and, in some countries, the timing of withdrawals; however, it would appear that a considerable fraction of workers have been dismayed by the wide array of options and decisions DC plans usually entail. In other cases, DC plan members may bear investment risk without having control over the asset mix, or, alternatively are provided with a limited choice of investment options that may make it difficult to design an optimum portfolio reflecting their unique investment obje ctives and constraints. Ultimately, plan regulation and design influences the extent to which DC plan members are able to manage financial risk. Employers offering DC plans escape financial and longevity risks associated with DB payments, but then are denied access to the opaque accounting of pension assets and liabilities in DB plans common in many countries, including the U.S., Canada, and until recently the U.K.. Pension accounting seems to have, at times, allowed some firms to obscure the costs of their pension plans and even the actual volatility and level of net income. 23 One risk that the employer may be forced to retain is the potential fiduciary/legal risk facing sponsors of DC pension plans. If employees retire from DC pension plans without sufficient retirement income this may be grounds for future lawsuits For example, Coronado and Sharpe (2003) show how the accounting of DB pension assets and investment returns tended to substantially boost the net incomes of U.S. plan sponsors during the market boom of the late 1990s. See also Wiedman and Goldberg To some extent, U.S. employers are protected against this risk by the safe harbour provisions contained in the U.S. Employee Retirement Income Security Act (ERISA) which specify the minimum requirements an employer must meet when establishing a DC pension plan

14 In principle investment returns should generate sufficient income for the average DC plan holder to retire with a comfortable income, provided contributions are made at a steady rate over the plan holder s career. A recent research paper by Andrew Samwick and Jonathan Skinner (2003) used simulations from a life cycle model calibrated to include realistic experiences for earnings, investment returns, and other key variables to compare whether typical DB plans or DC plans might leave workers better prepared for retirement. 25 Their study focused on the U.S. pension sector, using data from the Pension Provider Survey (PPS) that was part of the Survey of Consumer Finances in 1983 and 1989 to gather information about key characteristics of DB and DC plans in place at that time. What they found was that by 1995 the typical DC plan (one that fell into the 401(k) classification) would be expected to yield about the same retirement income for the median worker and higher income for the average retiree compared with the typical DB plan that was offered in the mid-1980s. The intuition behind their result is that investment returns, to a large extent, are uncorrelated over time, so that over the worker s career periods of low returns tend to be offset by periods of high returns and overall market risk is not such a big problem for many workers. By contrast, DB plans tended to tie retirement benefits strongly to earnings in the final years of work and, as discussed above, disproportionately to tenure at the firm, so workers were exposed to a significant degree of accrual risk. Across a typical range of risk aversion parameters, Samwick and Skinner found the costs of accrual risk tended to outweigh the costs from market risk. An important caveat to their main result is that failure to participate in an employer s DC plan would, of course, cut significantly into expected retirement income from that source. C. Hybrid Pension Plans Even within the DB category of pension plans, a shift has been underway, with quite a number of traditional DB plans having converted to hybrid plans that combine the features of both DB and DC plans. Under these types of arrangements the plans are typically treated as DB plans for tax, accounting and regulatory purposes but the benefits are expressed in terms of notional account balances which are often payable as a lump sum on retirement. The most popular of these is the so-called cash balance (CB) plan which was introduced in the U.S., but has become popular in some other countries (e.g., Japan and the U.K.) as well. In the U.S. model, participants in CB plans hold notional accounts that build with annual pay credits ( contributions ) plus interest. The pension benefit is expressed as a lump sum amount that can be redeemed upon retirement, at plantermination, or if a worker changes employers. In addition, pension benefits in CB plans typically accrue much more evenly over time compared with back-loaded, traditiona l DB benefits. Thus, like DC plans, CB plans allow workers to avoid the accrual risk associated with traditional DB plans, thereby providing more value to workers who might anticipate changing employers or moving in and out of the labour force over their career. Employers bear the responsibility to maintain funding for benefits accrued under CB 25 This paper is summarized in Samwick and Skinner (2004)

15 plans, so workers also avoid investment risk. In the U.S., some sponsors of DB plans were motivated to convert their traditional DB plans to CB plans to mitigate a portion of the costs of benefits that would soon accrue to their oldest workers. But, according to research by Coronado and Copeland (2003), the primary motivation for sponsoring firms to convert their traditional DB plans to CB plans was to design pensions for a more mobile workforce that particularly values the portability of retirement benefits. Growth in U.S. CB plans has slowed significantly in recent years, although this is related more to uncertainty about the legality of specific CB conversions than to firms having changed their minds about the net benefits of those types of pension plans. That said, according to researchers, a significant fraction of the DB universe converted their traditional plans to CB plans in the mid-to-late 1990s, including plans that had accounted for more than 10 percent of all DB sponsors and around a quarter of DB sponsors in the S&P 500. All told, something like a quarter of DB assets and nearly a third of workers in the DB system saw their plans convert to the cash balance form. 26 III. Extent of the Shift Away From Traditional DB Pension Plans A. Within the member countries of the OECD In this section we look briefly at the extent of the shift from DB to DC pension plans. The focus is mainly on OECD countrie s because the data are readily available, however, there has been considerable growth in the DC pension sector outside the OECD. Within the OECD, eight countries have already accumulated over 50 per cent of pension sector assets in DC plans, some of them having a relatively short history with funded occupational pensions. In contrast, there are a number of countries where DB plans remain the dominant form of pension, representing virtually all of sector assets in some cases (e.g., Norway). In one of these countries, the Netherlands, there has been considerable support for modifying and maintaining the DB pension system; regulatory reform has encouraged greater risk sharing between employees and employers, such as linking indexation of benefits to the funded status of the plan 27. In tandem with the shift towards DC plans in many established pension systems, a DC or hybrid model has been widely adopted in other countries that have reformed their pension systems in recent years. Countries that have recently moved to funded occupational pensions (e.g., Spain and Italy within the OECD and Poland, Czechoslovakia and Hungary within eastern Europe) have tended to favour a system based on DC or hybrid arrangements. 28 Within emerging market countries Malaysia has recently adopted a DC arrangement and Chile and Singapore are noteworthy in having longstanding DC pension systems. 26 The figures cited in the text are taken from Coronado and Copeland (2003). 27 In recent years, however, many final salary DB pensions have been converted to career average. According to Vlaar (2006), the proportion of final salary schemes declined from 67% in 1998 to 54% in 2003 and 14% in Some countries have implemented (Mexico) or have considered adopting (the U.S.) DC-style individual accounts for public pensions

16 Estimates of the relative share of assets and members in DB and DC pension plans are shown in Table 3 for selected OECD countries. Note that the data are for combined public and private sector plans and therefore tend to underestimate the extent of migration to DC plans in the private sector where it has mainly been occurring. Table 3: Relative share of assets & members in DB & DC funded occupational pension plans (public & private sector) in selected OECD countries Country Assets Members [1] DC plans DB plans DC plans DB plans Australia* n/a n/a Austria Belgium Canada Denmark* Finland* (partly funded) Germany (book reserve) Greece Iceland* Ireland Italy Japan Korea* Netherlands New Zealand n/a n/a Norway* n/a n/a Portugal Spain Sweden* United Kingdom United States Source: OECD Global Pension Statistics * indicates mandatory coverage ; Sweden, Germany and Austria use book reserve systems, not autonomous pension funds - The table exhibits data on assets for 2004 except for Australia (2005), Italy (2005), Japan (2003), Korea (2005), New Zealand (2005), Portugal (2005), Sweden (2003) and the United States (2005). In Canada the share in DC plans includes combined DC/DC plans. The DB/DC split for Australia was estimated by the Reserve Bank of Australia. - Data on relative share of plan members taken from Pension Markets in Focus, June Data are mainly for 2004 and include OECD staff estimates. [1] These figures should be considered rough estimates. Data from administrative sources can be affected by double counting (e.g., in situations where an individual has changed employers and has more than one pension) and/or classification difficulties arising when an employer offers more than one type of plan. What does the shift to DC pension plans mean in terms of the overall distribution of global pension sector assets? At the present time, the majority of pension sector assets (public and private sector) are held by countries with mature funded occupational pension systems originally based on traditional DB plans. Six of these countries - Australia, Canada, Japan, the Netherlands, the United Kingdom and the United States - account for

17 about 92 per cent (US$14.4 trillion in 2004) of occupational pension sector assets within the OECD (see Appendix 1). In these countries, DC plans represent an estimated onethird of total sector assets, but as noted earlier the share in private sector plans is much higher. Over time as more countries move to funded pension schemes and as more employers adopt this type of pension plan the pace of asset accumulation in DC pension plans could increase considerably. If the trend towards DC plans continues, the assets held in DC pension plans will eventually exceed those held in DB pension plans, making DC plans one of the largest institutional investors. However, for the foreseeable future it is the investment decisions of DB pension plans that will have the greatest influence on global financial markets. B. Trends in Australia, Canada, the United Kingdom and the United States In this section we examine the shift from DB to DC pensions in somewhat more detail for Australia, Canada, the U.K. and the U.S. In contrast to the previous section we focus on private sector plans wherever possible. The narrative in subsequent sections of this report draws heavily on information available for these countries. For voluntary employer pensions, the shift toward DC pension plans is most pronounced in the U.S. (Table 4). The number of active participants in U.S. DB plans was essentially flat from about the mid-1970s through the mid -1980s, while the number of DC participants grew rapidly. By 2004, about 65 million workers were covered by DC plans compared to about 25 million in DB plans. Similarly the size of assets in DC plans has shown considerable growth. According to data in the U.S. Flow of Funds Accounts, in 1985, private-sector DB plans held about US$800 billion in total financial assets, while private-sector DC accounts contained around US$425 billion. The latter is a conservative measure because members leaving an employer s DC pension plan are permitted to roll over their assets into an Individual Retirement Account (IRA). 29 IRAs amounted to about US$250 billion in Whereas assets in private-sector DB plans had more than doubled to nearly US$2 trillion by year-end 2004, assets in private-sector DC accounts had soared to US$2.7 trillion and IRA balances to US$3.5 trillion. As show n in Chart 1, the value of assets held in DC plans, excluding IRA balances, had exceeded the value of assets held in DB plans by the mid-1990s. 29 These are individual retirement savings accounts rather than an employer pension plan

18 Table 4 Percentage Share of Assets and Members in DB and DC Pension Plans Private Sector (unless otherwise specified) DC only DB only Combination Assets Members Assets Members Assets Members Australia (both sectors) Canada United Kingdom n/a n/a United States n/a n/a Sources: A ustralian Prudential Authority, June 2005; Statistics Canada, 2004; U.S. Federal Reserve Board, 2005; UBS 2005; U.K. Government Actuary Department, The totals do not include assets rolled-over from pension plans into individual tax -free accounts such as IRAs Data is for trusteed plans and does not include insurance contracts, personal pensions or RRSPs Chart 1: Percentage Share of Assets in US DB and DB Pension Plans: % 65% 60% 55% 50% 45% 40% 35% 30% DB DC In Australia, the shift towards DC pension plans is more advanced than in the other countries and coverage is extended to most of the workforce. A change in pension legislation that introduced mandatory employer pensions is the main factor contributing to the shift from DB to DC pension plans. 30 Prior to this, employer pe nsion coverage was limited to a small share of the workforce, similar to the experience of other countries such as the U.K., Canada and the U.S. The transition to DC pension plans began with the introduction, in 1986, of award superannuation which required that part of an employee s pay increase would take the form of a superannuation payment. It accelerated markedly 30 Australia is one of the few countries in the OECD with a mandatory occupational pension system, although unlike many other OECD countries it does not have a public earnings-related pension. Award Superannuation has been a success in Australia, increasing pension coverage dramatically (to about 90% of the workforce by 2002 according to Australia s statistical agency). See Bateman and Piggot

19 under the compulsory Superannuation Guarantee (SG) introduced by the Australian government in Under SG employers were required to make contributions (currently at 9% of earnings) on behalf of their employees. These innovations were designed around a DC framework; employers with existing DB plans have, over time, downsized and closed off these plans. Consequently, the type of pension benefit offered by employers has shifted markedly towards DC pension plans. Data from the Australian Prudential Regulation Authority (APRA) shows that as of mid-2005, 66 per cent of pension plan members were in DC plans compared to two per cent in DB plans and 32 per cent in combination plans (the majority of these would be plans where the firm is sponsoring both a DB and DC pension plan, rather than true hybrid plans). In terms of sector assets, only four per cent remain in DB only pension plans; 50 per cent are in DC only plans while 47 per cent are in combined DB/DC plans. The Reserve Bank of Australia estimates that most of the latter are assets held in DC plans. In total, an estimated 10 per cent of assets in combination plans are held on behalf of DB schemes. In the U.K., the shift towards DC pension plans began in the 1990s. By most accounts the pace has increased considerably since 2000, reportedly driven in part by changes in pension regulation and accounting. While there is considerable evidence to support the shift towards DC plans, its precise magnitude is somewhat uncertain; the results of various membership surveys are at times inconsistent and difficult to interpret. According to the 2005 survey of regulated occupational pension plans by the Government Actuary s Department (GAD), 42 per cent of active members in DB pension schemes belong to plans that have been closed to new members. 31 The GAD surveys show that membership in private sector DB plans declined considerably between 1995 and 2005, from 5.16 to 3.66 million members. At the same time, information from the Employers Pension Provision Survey shows only 2.5 million workers in DB pension plans. The GAD survey also shows the number of DC plan members falling from 1.06 to 1.02 million. Data inconsistencies aside, there is little doubt that the shift away from DB pension plans has accelerated in recent years. The Pensions Commission (2004) estimates that while active membership in DB plans has fallen 60 per cent since 1995, most of the shift has occurred since The National Association of Pension Funds survey (2005) found that DC plans have become the most common form of private sector employer pension: 62 per cent of employers offer a money purchase plan; 24 per cent offer a stakeholder pension; and 46 per cent offer a DB plan. Private sector consultant surveys are consistent with these findings showing that most U.K. employers now offer DC pension plans, including many large employers GAD In the same report the GAD reported that nearly 50 per cent of DB pension plans were either frozen or closed to new members. 32 For example, Watson Wyatt (2005) notes that the shift towards DC plans has increased in recent years and is not just limited to smaller employers. In their survey of FTSE 100 firms they found that 81 per cent (of 83 respondents) offer a DC plan to which the employer contributes. See also Greenwich

20 Unfortunately, administrative and/or survey data showing the share of pension sector assets held in DC pension plans is not available for the U.K.. A widely cited estimate is include d in a recent report by UBS Global Asset Management (2006) in which it was reported that DC plans account for about 20 per cent of U.K. pension sector assets. In contrast, a survey of a limited number of U.K. pension funds conducted by Greenwich Associates (2005) found that for the 82 per cent of survey respondents offering a DC plan, only 3 per cent of total assets were invested in DC plans. It is possible that these firms had only recently made the shift to a DC plan and hence few assets had accumulated. In Canada, the shift from DB to DC pension plans is considerably less evolved than it is in the U.S., despite the close integration of the U.S. and Canadian economies and the many similarities in their pension systems. Anecdotally, many industry professionals attribute this to differences in culture, one reflection of which is a higher level of workforce unionization. Brown and Liu (2001) argue that a higher level of unionization in Canada relative to the U.S. is one factor supporting the persistence of DB pension plans. They also note that differences in pension regulation and tax policy have been important as well. While there are a number of possible explanations, it is clear that a large migration towards DC pension plans has not yet occurred in Canada. At the same time there is evidence that few new DB plans have been created over the past decade or so. In 1992 about 6.8 per cent of private sector trusteed 33 pension plan members were in a DC plan, less than one per cent were in combination (DB and DC) plans and 92.5 per cent were in DB plans. By 2004 the share of members in DB plans had declined to 77.1 per cent while the share in DC plans showed a slight increase to 7.6 per cent. The main change over the period was an increase, to nearly 12 per cent, in the number of members belonging to a combination plan. This is likely a reflection of the fact that in Canada, the principal means of freezing a DB pension plan is to close the plan to new members while maintaining the DB plan for existing members. 34 In terms of assets, less than four per cent of sector assets are in DC only plans, however, similar to Australia, the total share of sector assets in DC plans is somewhat higher because some portion of the 13 per cent of assets in combination plans belong to DC plan members. Anecdotal and survey evidence suggest that the shift towards DC pension plans may have increased in recent years. 35 Hewitt Associates (2004) in a survey of a diverse group of 174 Canadian firms sponsoring a DB plan, found that while 49 per cent of 33 Excludes occupational pension plans organized as insurance contracts. 34 Current reporting practices do not distinguish between true hybrid plans and multiple DB/DC plans covering different groups of employees at the same firm. The category combination plans may capture some hybrid plans but in most cases it is likely capturing the situation where employers offer a DC plan to new hires while continuing to maintain the older DB plan. See Anderson, The available administrative/survey data suffers from a lack of timeliness and fails to explicitly capture some changes occurring in DB plans, e.g., when existing DB plans are closed to new members